Category Archives: Economics essays

Economics essay 2: why global trade is going into reverse

Now for the second essay on economics that I wrote in 2008. The topic is trade, and it investigates the theory of trade between developed and developing nations. It turns out that standard trade theory, based on comparative advantage, works rather well here. But it contains a prediction that goes largely unremarked. Apart from Paul Samuelson (in 2004) I haven’t seen anybody else raise the point. And yet it does much to explain what is going on in the world now, especially between Britain and China.

The theory of comparative advantage is part of what Americans call “Economics 101”: basic first year economics. It explains how mutual trade can benefit economies even when one is manifestly more efficient than the other. But generally this wonderful piece of logic, made famous two centuries ago by David Ricardo, fails to advance much beyond Economics 101. Modern economists have not found ways of using it to make concrete predictions. Attempts to make the theory more specific, for example by relating it to availability of factors of production (like land, capital, etc.) have come to not much. Instead the idea is used to give a warm glow to the idea of trade being a Good Thing, and the basis of patronising comments to non-economists advocating protectionism, while economists get on with the day job without touching it.

That is a pity, because the theory repays more examination. Its central idea is that gains from trade are based on opportunity costs of the various products in an economy, or comparative advantage – that is how much of one product you have to forgo to produce a given quantity of another. The corollary is that where the differences in opportunity cost are minimal, the gains from trade are likewise minimal. As different economies converge, the less incentive there is to trade.

In fact trade does take place between similar economies, but it is driven by other factors, such as economies of scale, and is quite sensitive to transport costs. But the theory of comparative advantage does explain trade between developed and emerging economies rather well. These economies are self evidently very different from each other, and gains may be made between countries on opposite sides of the globe. But as emerging economies develop; they converge with developed economies. What happens then?

To explore this I created a simple mathematical model. I divided the economy into four sectors: agriculture, where productivity grows, but which is not traded; services, also not traded, but where no productivity changes happen; and two types of goods, high and low tech, which are tradable and where productivity changes at differing rates. I looked at three stages of development. The first, undeveloped stage has a huge and inefficient agriculture sector. In the second, intermediate, stage, low tech manufacturing has got going. In the final developed economy stage, productivity has advanced in all sectors apart from trade, but especially in high tech goods.

I then looked at how trade would work between the developed and undeveloped economy. There was no major impact, but the undeveloped economy would buy all its high tech goods from the developed one, in exchange for low tech goods.  The undeveloped economy’s currency traded at well below purchasing power parity. Next I considered what would happen if the undeveloped economy moved to the intermediate stage. Now trade becomes much more important to both economies; once again the intermediate economy buys all its high tech goods from the developed one, in exchange for low tech goods. But the developed economy imports a high proportion of its low tech goods. Both sides gain substantially.

But what happens as the economies converge further? The trade disappears; the developing economy supplies an increasing proportion of its high tech needs, and exports fewer low tech goods, substituting productivity gains for gains from trade. The developed economy has to supply its own low tech goods again, and loses gains from trade. It is worse off.

All this models what has been happening between Britain and China quite well. Nothing much at first, but as China’s agriculture became more efficient, and so its low tech manufacturing could grow, then trade ballooned, with gains to both sides. This took place in the 1990s and early 2000s. The price of manufactured goods in Britain dropped because of cheap imports, allowing other goods and services, and pay, to grow at a healthy 4% per annum or so, while keeping overall inflation at about 2%; the components of the inflation statistics became very revealing. A lot of the economic growth that took place in Britain in this period was surely driven by this, rather than advancing productivity.

But even in 2008 I could see that the party was coming to an end. Chinese costs were rising; they were moving increasingly into high tech areas. It has become harder for Britain to compete for high tech goods, but easier to repatriate lower tech manufacturing and services. This latter has been good for British jobs, but not for living standards, as what is being repatriated has lower productivity. Volumes of trade have fallen – though it is a complex affair so cause and effect are hard to prove.

Won’t China be replaced by other countries? Japan started the trend after all, to be replaced by the “Asian Tigers” (South Korea, Taiwan, etc.), before China entered the picture. There are emerging economies that are taking up some of the slack – Vietnam and Bangladesh, perhaps. Africa has huge scale. But not only are many of these economies slow to transition to the intermediate stage, with a strong export manufacturing base, but the sheer scale of China changes things. The emerging economies are as likely to trade with China (and India, whose emergence takes a different but parallel path) as they are with the developed world. And perhaps low tech is becoming more high tech too – making it hard for the newly emerging economies to find enough of scale where they have a comparative advantage.

And this is yet another reason why developed economies appear to be stagnating, and why much of the growth that took place before the crash of 2008 was unsustainable. Trade has a reverse gear that is nothing to do with protectionism and ignorance of economic theory. Economic theory predicts it.

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Economics essay 1: economic growth will come to an end naturally

Last week I was looking for something I had written a few years ago, and I found two essays that I had written in 2008. I was trying to clarify my thinking on economics, using the device of explaining the discipline to a non-economist. They were meant to be the start of a longer series, but alas the rest of life intruded. I have decided to publish them through this blog, and to try and extend the series.

My blog posts are long enough (over 1,000 words a piece, usually), but they are not long enough to develop thinking properly. And the pressure to get two posts out a week is not conducive to deep thought either, as the rest of my life is proving quite active, even though I am now retired.   These essays are longer (the first just under 2,500 words), and certainly more considered.

Both of the essays developed ideas that I have used in my blogging since. The first is that there is a natural limit to economic growth – which I am now convinced we are reaching. The second looks at trade, and especially that between developed and developing nations – and why this leads to gains that are then reversed in developed economies. A further feature of the essays is that they frame economic ideas in a historical, or evolutionary, context. One thing leads to another and society changes. This is a break from the idea of a static equilibrium that dominates much economic thought. Economists even try to give a static quality to dynamic concepts, like growth and productivity change, by treating them as constants. Sometimes they produce data series of 200 years and more, as if to suggest that nothing really changes.

I wrote the essays just after I finished my degree in Economics at UCL as a mature  student. But it was before the collapse of Lehman Brothers precipitated what we now understand as the Financial Crash, though it had been clear from 2007 that the world’s financial system was teetering on the brink.

I have edited the essays (a job not yet finished for the second one) so as to correct mistakes and clarify language – but I have avoided a rewrite, even though I would write differently now. Partly this is to preserve authenticity; mainly because a rewrite would take much longer. What you read is how I saw things then. I will use the covering blog post to offer any new insights.

So what of the first essay: Wealth, wellbeing and growth? This explores the idea that economic growth might come to a end simply through the freely made choices of the people. This is not a line of thinking that I can remember any modern economist trying to develop, although it was foreshadowed, as so much in modern economics is, by Maynard Keynes.

This idea follows from four observations: that consumption for personal needs will reach saturation; that productivity gains allow increased consumption of things, but cannot change human content, and so make their products less attractive; that leisure holds a compelling attraction to those who can afford it; and that the quest for status is a zero-sum game.

Increasingly we want things that economic growth cannot deliver in greater quantities: land, leisure and fame. Technology change is not necessarily leading to increased productivity, while still delivering things that we want. Wellbeing may advance without growth. Though many in our society clearly need to consume more than they do – we still have poverty – that does not imply that increased consumption for everybody, even as an average, is the way forward people will choose. Economists are quite unready for this.

So what has changed since 2008? The crash may suggest the unsustainability of ever increasing consumption, especially if it fuelled by debt. I hint at this idea without developing it. Since then growth has become a political obsession – so the idea that it might not be considered to be an outright good has even less currency. The Greens have dropped their low growth rhetoric and replaced it with something that is quite ambiguous. The left has chosen “austerity” as top of their most hated abstract nouns, on the grounds that it is an attack on growth, though also on grounds of another abstract idea: “social justice”.

So we have a long way to go before my idea will get any political traction. And yet the idea of secular stagnation, is gaining ground. This is seen as a Bad Thing, of course, but its roots can be traced to as far back as the 1990s.  This is the idea that there is a structural excess of savings over investment in developed economies, which undermines growth – which is only sustained, by ever increasing cycles of debt growth and asset price bubbles. I think the ideas that I am suggesting in the essay are part, even most, of the explanation for secular stagnation.

There are some twists, though. Inequality may be an important factor in the process of saturation of consumption – a growing share of income is going to a rich elite, who are unable to spend it. This may imply that a more efficient distribution of wealth would increase consumption and lead to growth. But only up to a point, surely.

There clearly is a dark side to my idea. Demand for tax-funded services is voracious (hence the anger of some against “austerity”) – but what is to be taxed in a low-growth world? And the addiction of our economies to debt requires growth to feed it; it will not be broken without a lot of social stress.

But that is the way the world is heading – and it is as well that we think the implications through.

 

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